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A book review of The Ultimate Dividend Playbook,: Income, Insight and Independence for Today's Investor by Josh Peters, CFA and Morningstar analyst
Let me be upfront, I am a fan of dividend investing in general and Josh’s Morningstar Dividend Investor Newsletter in particular. As an early retiree I have been struggling with a way to have enough income to enjoy life, while protecting my nest egg from the ravages of inflation.
I think this is a valuable book for the intermediate or advance investor to own for two reasons. First, while dividend investing has become somewhat trendy in the last couple of years, there hasn’t been much in depth analysis of why dividends matter. Secondly, the truly outstanding portion of the Dividend Playbook is it teaches the average investor how to search out and evaluate dividend stocks, and figure out which are likely to be good investments. Overall, the Playbook is the rare business book that does a better job teaching you how to catch fish, than making the case why you should eat fish!
Target Audience.
I think anybody who is a current or potential M* Dividend Investor Newsletter subscriber would be crazy not to buy this book, it is a fraction of the cost of the newsletter, and makes the newsletter much more valuable. I’d also commend it to any do it yourself stock picker. I think it would be valuable people looking at purchasing dividend ETF like DVY or mutual funds. A beginning investor who isn’t really comfortable with terms like Return on Equity, or an index fund investor, or 401K investor doesn’t really need it.
Why dividends?
Josh quickly nailed my biggest problem as a retiree depending on an equity heavy (80%) investor. It is awfully hard to figure out when to buy a stock and even harder to know when to sell. I think even for a pure index fund investor with a 50% stock/bond mix who is rebalancing his portfolio in Jan 2008, must be uneasy with recent market volatility. I am sure many ask themselves, do I really want to buy more stocks? They have gone down a lot in the last couple of months. For the individual stock investor figuring out which stocks are overpriced and what is underpriced is way to much work. According to Josh, the beauty of the dividend income approach is by relying on income you are letting the stock do the work for you. As long as the companies keep paying dividends and they continue to grow there is no need to worry about how manic depressive Mr. Market feels about your stocks today or tomorrow.
The first few of chapters make the case for dividend investing being superior. I was most interested in Professor Jeremy Siegel (of Stocks for the Long Run fame) study of the top 100 highest yielding stocks in the S&P 500 earning an average of 14.3% annually while the lowest 100 yielding making only 9.5% annually between 1958 and 2003. Several other shorter term (10-25 years) studies were also cited showing the superiority of dividend investing. One of my main criticism of the book, is I don’t think nearly enough time was devoted (only few pages out of 335) to bolstering Josh’s claim “There’s no good reason an investor needs to own any non dividend paying stock at all”. Not only would Google shareholders disagree but so would Berkshire Hathaway shareholders. I’d love to see a great deal of more effort to examining historical studies of dividend investing.
His philosophical case for why dividends are good for shareholders is quite strong. Imagine a company which makes $200 million in profit. It can reinvest $100 million in it is core business which has historically earn 20% on equity, there is also a $100 million opportunity to acquire another business which if all goes well may earn 15%, In the absence of dividends, both projects are likely to be funded. As we all know the number of can’t miss acquisitions which have flopped is huge. If on the other hand, the company has historically paid out $100 million in dividends management is likely to pass on the risky acquisitions. One particularly interesting insight was the case against share paybacks. All too often management announces buybacks but don’t follow through, even more troubling is share buybacks award EX shareholders not the existing loyal shareholders. If management want to keep stable base of shareholder dividends are a much better approach.
The Dividend Drill
The meat of the book is in Mr. Peter approach to evaluating dividend stocks which he calls the Dividend Drill. The drill is familiar to his newsletter readers, but I never completely understood it until reading the book. The simplest part is the insight that the total return of a stock is equal to the current dividend yield + dividend growth rate. Thus a stock currently yields 4% and has been growing dividends at 6% in the past and is likely to do so in the future its long term total return is 6%+4%=10%. Johnson and Johnson is a classic example with a yield which has been around 2% for most of the last 30 years, but with a dividend growth rate of 14%. The total return on JNJ including reinvesting dividends has been 16% over a 30 year period. Many other stocks have shown strong correlation between dividend yield+growth and total return; examples include Utilities like Con Ed with 5.5% yield and 1% growth rate and Realty Income (O) with a 7% yield and 3.7% div growth rate.
The crux of the dividend drill is evaluating a dividend stock on three critical elements; is the dividend safe, can the dividend grow, and what’s the return? There is high school level math involved and balance sheet 101 knowledge is definitely needed (I have an MBA so I pass!), however it isn’t very complex. Mr. Peters does a good job of providing concrete examples and nice step by step explanation.
Dividend safety is a relatively simple calculation; do the projected earnings exceed next year’s dividend by a comfortable margin? Josh explains that the safety margins (aka payout ratio) for a cyclical industry need to be considerable higher than a natural gas pipeline company. Will it grow is probably the most difficult calculation to make. There are numerous things to consider, management’s commitment to growing dividends, the core potential growth rate, obviously microchip companies have a higher potential growth rate than potato chips companies, and small companies better potential than large companies. Future earnings growth and return on equity are also factors.
Josh then discusses how to calculate total return and emphasis the importance of setting hurdles. In general Josh finds a sweet stock with stocks yielding between 4-7%. Stocks yielding above say 9% are at risk of having a dividend cut, stocks yielding 2% or below require very high growth rates. This sweet spot is important to retirees because a 4% Safe Withdrawal Rate requires growth at the rate of inflation. If Mr. Bear market or Sub prime Scandal comes along and cuts the price of your 4% dividend payer by 25% you can pretty much ride out the market with your income intact. On the other hand, the yields aren’t so high that a dividend cut is likely because of dropping earnings. Overall Josh is looking for companies which will provide a total return in the 9-11% only a couple of percent higher than his 8% total return estimate for the overall market going forward. (FYI, pretty much in line with Buffett and others estimates.) Still a 1-2% reliable return over the market translates into a hefty increase in disposal income for a retiree or near retiree.
The final chapters of the books discuss managing a dividend portfolio. He gives some helpful advice about picking a target income need and designing a portfolio around that. Not surprisingly the portfolio construction is very similar to the M* dividend investor newsletter portfolio. The lack of diversification (e.g. heavy emphasis on financial) could be worrisome to some investor. However, there is something to be said about Mr. Peters, Warren Buffett, and Marty Whitman, argument that it is better to own 10 stocks you know than 500 you don’t know. One of my other criticisms of the book is that the all important discussion of when to sell is definitely glossed over.
Some of the most valuable section of the books is the 6 appendixes, which discuss the mechanism of dividend payments, tax treatments, and investing in Utilities, Master Limited Partnerships (MLPs), REITs, and Bank Stocks, respectively. The last three areas are particularly good places to look to find high yielding dividend stocks. However, they require an additional approach to evaluating the potential returns. I was particular pleased with these appendix, because having learned the basics of fishing, it is very helpful to learn the tricks involved in fly fish, ocean fishing, and bass fishing, because the more you know the less chance you have of going hungry!
Overall, I am much more confident about investing in dividend stocks thanks to this book. I intend to continue to emphasis individual dividend stocks, for the non-index portion of my portfolio.
Let me be upfront, I am a fan of dividend investing in general and Josh’s Morningstar Dividend Investor Newsletter in particular. As an early retiree I have been struggling with a way to have enough income to enjoy life, while protecting my nest egg from the ravages of inflation.
I think this is a valuable book for the intermediate or advance investor to own for two reasons. First, while dividend investing has become somewhat trendy in the last couple of years, there hasn’t been much in depth analysis of why dividends matter. Secondly, the truly outstanding portion of the Dividend Playbook is it teaches the average investor how to search out and evaluate dividend stocks, and figure out which are likely to be good investments. Overall, the Playbook is the rare business book that does a better job teaching you how to catch fish, than making the case why you should eat fish!
Target Audience.
I think anybody who is a current or potential M* Dividend Investor Newsletter subscriber would be crazy not to buy this book, it is a fraction of the cost of the newsletter, and makes the newsletter much more valuable. I’d also commend it to any do it yourself stock picker. I think it would be valuable people looking at purchasing dividend ETF like DVY or mutual funds. A beginning investor who isn’t really comfortable with terms like Return on Equity, or an index fund investor, or 401K investor doesn’t really need it.
Why dividends?
Josh quickly nailed my biggest problem as a retiree depending on an equity heavy (80%) investor. It is awfully hard to figure out when to buy a stock and even harder to know when to sell. I think even for a pure index fund investor with a 50% stock/bond mix who is rebalancing his portfolio in Jan 2008, must be uneasy with recent market volatility. I am sure many ask themselves, do I really want to buy more stocks? They have gone down a lot in the last couple of months. For the individual stock investor figuring out which stocks are overpriced and what is underpriced is way to much work. According to Josh, the beauty of the dividend income approach is by relying on income you are letting the stock do the work for you. As long as the companies keep paying dividends and they continue to grow there is no need to worry about how manic depressive Mr. Market feels about your stocks today or tomorrow.
The first few of chapters make the case for dividend investing being superior. I was most interested in Professor Jeremy Siegel (of Stocks for the Long Run fame) study of the top 100 highest yielding stocks in the S&P 500 earning an average of 14.3% annually while the lowest 100 yielding making only 9.5% annually between 1958 and 2003. Several other shorter term (10-25 years) studies were also cited showing the superiority of dividend investing. One of my main criticism of the book, is I don’t think nearly enough time was devoted (only few pages out of 335) to bolstering Josh’s claim “There’s no good reason an investor needs to own any non dividend paying stock at all”. Not only would Google shareholders disagree but so would Berkshire Hathaway shareholders. I’d love to see a great deal of more effort to examining historical studies of dividend investing.
His philosophical case for why dividends are good for shareholders is quite strong. Imagine a company which makes $200 million in profit. It can reinvest $100 million in it is core business which has historically earn 20% on equity, there is also a $100 million opportunity to acquire another business which if all goes well may earn 15%, In the absence of dividends, both projects are likely to be funded. As we all know the number of can’t miss acquisitions which have flopped is huge. If on the other hand, the company has historically paid out $100 million in dividends management is likely to pass on the risky acquisitions. One particularly interesting insight was the case against share paybacks. All too often management announces buybacks but don’t follow through, even more troubling is share buybacks award EX shareholders not the existing loyal shareholders. If management want to keep stable base of shareholder dividends are a much better approach.
The Dividend Drill
The meat of the book is in Mr. Peter approach to evaluating dividend stocks which he calls the Dividend Drill. The drill is familiar to his newsletter readers, but I never completely understood it until reading the book. The simplest part is the insight that the total return of a stock is equal to the current dividend yield + dividend growth rate. Thus a stock currently yields 4% and has been growing dividends at 6% in the past and is likely to do so in the future its long term total return is 6%+4%=10%. Johnson and Johnson is a classic example with a yield which has been around 2% for most of the last 30 years, but with a dividend growth rate of 14%. The total return on JNJ including reinvesting dividends has been 16% over a 30 year period. Many other stocks have shown strong correlation between dividend yield+growth and total return; examples include Utilities like Con Ed with 5.5% yield and 1% growth rate and Realty Income (O) with a 7% yield and 3.7% div growth rate.
The crux of the dividend drill is evaluating a dividend stock on three critical elements; is the dividend safe, can the dividend grow, and what’s the return? There is high school level math involved and balance sheet 101 knowledge is definitely needed (I have an MBA so I pass!), however it isn’t very complex. Mr. Peters does a good job of providing concrete examples and nice step by step explanation.
Dividend safety is a relatively simple calculation; do the projected earnings exceed next year’s dividend by a comfortable margin? Josh explains that the safety margins (aka payout ratio) for a cyclical industry need to be considerable higher than a natural gas pipeline company. Will it grow is probably the most difficult calculation to make. There are numerous things to consider, management’s commitment to growing dividends, the core potential growth rate, obviously microchip companies have a higher potential growth rate than potato chips companies, and small companies better potential than large companies. Future earnings growth and return on equity are also factors.
Josh then discusses how to calculate total return and emphasis the importance of setting hurdles. In general Josh finds a sweet stock with stocks yielding between 4-7%. Stocks yielding above say 9% are at risk of having a dividend cut, stocks yielding 2% or below require very high growth rates. This sweet spot is important to retirees because a 4% Safe Withdrawal Rate requires growth at the rate of inflation. If Mr. Bear market or Sub prime Scandal comes along and cuts the price of your 4% dividend payer by 25% you can pretty much ride out the market with your income intact. On the other hand, the yields aren’t so high that a dividend cut is likely because of dropping earnings. Overall Josh is looking for companies which will provide a total return in the 9-11% only a couple of percent higher than his 8% total return estimate for the overall market going forward. (FYI, pretty much in line with Buffett and others estimates.) Still a 1-2% reliable return over the market translates into a hefty increase in disposal income for a retiree or near retiree.
The final chapters of the books discuss managing a dividend portfolio. He gives some helpful advice about picking a target income need and designing a portfolio around that. Not surprisingly the portfolio construction is very similar to the M* dividend investor newsletter portfolio. The lack of diversification (e.g. heavy emphasis on financial) could be worrisome to some investor. However, there is something to be said about Mr. Peters, Warren Buffett, and Marty Whitman, argument that it is better to own 10 stocks you know than 500 you don’t know. One of my other criticisms of the book is that the all important discussion of when to sell is definitely glossed over.
Some of the most valuable section of the books is the 6 appendixes, which discuss the mechanism of dividend payments, tax treatments, and investing in Utilities, Master Limited Partnerships (MLPs), REITs, and Bank Stocks, respectively. The last three areas are particularly good places to look to find high yielding dividend stocks. However, they require an additional approach to evaluating the potential returns. I was particular pleased with these appendix, because having learned the basics of fishing, it is very helpful to learn the tricks involved in fly fish, ocean fishing, and bass fishing, because the more you know the less chance you have of going hungry!
Overall, I am much more confident about investing in dividend stocks thanks to this book. I intend to continue to emphasis individual dividend stocks, for the non-index portion of my portfolio.
